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ETF Specialist

Hidden Value in Small-Cap Dividends

While it doesn't take a traditional approach, this small-cap dividend ETF offers one of the best ways to unlock the value premium.

Holdings can say a lot about a fund's investment style, but they don't always tell you everything. Take  WisdomTree SmallCap Dividend (DES) for example. It invests in dividend-paying small-cap companies that meet certain liquidity requirements. It then weights them by the dollar value of dividends they are expected to pay out over the next year. While its holdings skew toward the small-value side of the Morningstar Style Box, on average they trade at richer valuations than the holdings of its peers, which explicitly target small-value stocks (see the Portfolio Characteristics table below). Yet, since its inception in July 2006, DES has behaved like a deeper value fund than nearly all of its peers.

The fund's performance revealed its true colors. Just a few factors can explain most of the returns on a broad stock portfolio, including the portfolio's sensitivity to the market, value, momentum, and small-cap premiums. These are well-documented sources of return. Value stocks tend to outperform growth stocks, small caps tend to do better than large caps, and stocks with high momentum continue to outpace their low-momentum counterparts. By regressing a fund's returns on each of these factors, we can evaluate where its returns actually come from. For instance, if a fund does well when value stocks do well, then it behaves like a value fund, even if it doesn't own value stocks.

The following table illustrates the results of this analysis for DES and four of its peers, using data from July 2006 through June 2013. The coefficients from the regression in the table represent the corresponding fund's sensitivity to each premium. For example, a value coefficient of 1.0 indicates that the fund tends to increase in value by 1% when deep-value stocks outperform high-growth stocks by 1%, holding all other factors constant.

Although DES doesn't specifically target value stocks, it exhibited the greatest sensitivity to the value premium--nearly twice that of  Vanguard Small Cap Value (VBR), which owns the cheaper half of the U.S. small-cap market. IShares Russell 2000 Value Index (IWN) offers similar exposure to VBR. It even has a stronger value tilt than  DFA US Small Cap Value (DFSVX) and iShares Morningstar Small Value Index (JKL), which target the cheapest fourth and third of the small-cap market, respectively.

DES' dividend-weighting approach may offer a partial explanation. When it rebalances, the fund increases its exposure to stocks that have become cheaper relative to their dividends and pares back on those that have become more expensive, regardless of where these holdings fall in the style box. This dynamic approach may allow the fund to capture the value premium more effectively than many of its peers. Some stocks clearly warrant higher valuations than others, either because they carry less risk, greater profitability, or faster growth (though the latter is often overvalued). Consequently, many stocks that trade with low valuations are fairly priced. The fund's dividend-weighting approach offers a stronger bet on mean reversion than targeting stocks trading at low valuations, as many of its peers do. It keeps some traditional growth and blend stocks in the portfolio but allows investors to profit when these stocks are temporarily mispriced. In this way, the fund's rebalancing approach more closely resembles the way that active managers think about value than traditional value index funds.

The fund's narrow focus on dividends also enhances its sensitivity to the value premium. Despite their size, small-cap dividend-paying stocks also tend to be more mature than their non-dividend-paying counterparts. For instance, the fund's top holding,  R.R. Donnelley , operates in the declining printing industry and has experienced flat sales growth and declining profits over the past three years. Lexmark International and cigarette maker Vector Group (VGR), also among the fund's top holdings, face similar low-growth environments. Many of these holdings may be forced to cut their dividends during recessions. However, they offer attractive compensation for this risk and may have a better chance of beating the market's expectations than their faster-growing peers.

A Steady Stream of Benefits
Dividend investing has a lot to recommend it. Although capital gains drive short-term performance, dividends increase in importance with the length of the investment horizon. Dividend-paying stocks have historically generated superior returns than non-dividend-paying stocks in most markets and time periods studied, with less risk. This may be partially because dividends impose greater discipline on managers by reducing their capacity to engage in value-destructive empire-building. Growth can be tantalizing. Manager compensation is often positively correlated with firm size. Armed with a large pile of cash, managers may be tempted to expand the business through investments in risky projects and acquisitions, even when doing so is not in shareholders' best interests. Dividend payments reduce firms' access to easy capital and create a higher hurdle to undertake new projects, which can benefit shareholders.

Managers can also use dividends to signal their confidence in their firms' future business prospects, particularly when they raise these payments. In a study published in 2006, Ping Zhou and William Ruland found that stocks with higher dividend payouts also experienced faster earnings growth. While this study only covered dividend-paying stocks, it is consistent with a signaling story. Investors tend to severely punish companies that cut their dividends. Consequently, managers are reluctant to commit to dividend payments unless they are confident they will be able to honor them over the full business cycle. Because of this constraint, dividend paying stocks tend to be more profitable and generate more-stable cash flows than non-dividend-paying firms. For instance, the average return on invested capital of the fund's holdings (6.1%) dwarfs the corresponding figure on the Russell 2000 Value Index (1.2%).

Therefore, it shouldn't be surprising that the fund exhibited a lower downside capture ratio than both its peer group and the Russell 2000 Value Index over the past five years. It was also slightly less volatile than the small-value category average during that time. Dividends help dampen the fund's volatility because investors immediately benefit from these payments, while there is more uncertainty about the value of future growth. Although some firms may cut their dividends during recessions, dividends tend to be more stable than earnings. Investors in this fund will be paid to wait out the bad times.

While large-cap dividend-paying stocks tend to be more stable and have greater capacity to weather recessions than their small-cap counterparts, the fund has two things going for it. First, it offers a more attractive dividend yield than  WisdomTree LargeCap Dividend (DLN). But more importantly, the value premium has historically been larger among small-cap stocks. Wall Street analysts do not cover many of these firms, so there is a greater potential for mispricing. However, that also exposes investors to greater risk.

Although chasing yield can skew a portfolio toward low-quality holdings, the fund's dividend-weighting approach helps limit this risk because it allows both firm size and yield to influence each holding's weighting in the portfolio. This hybrid approach reduces the weighting of distressed companies in the portfolio relative to a more naive yield-weighting formula.

Nuts and Bolts
The fund tracks the WisdomTree SmallCap Dividend Index, which represents the smallest 25% of the broad WisdomTree Dividend Index by market cap, after the largest 300 companies have been removed. This broad reach sweeps in more than 600 small-cap dividend-paying stocks. WisdomTree weights each holding according to the dollar value of dividends it is expected to pay out over the next year relative to aggregate value of all the companies in the index, based on the most recent dividend. For example, a stock that pays out $2 million in dividends will receive twice the weight as a firm that pays out $1 million. The index is rebalanced annually. Relative to the Russell 2000 Value Index, the fund overweights industrials, consumer defensive, and utilities stocks, and significantly underweights financials.

Investors who find this approach appealing will have to put up with a 0.38% expense ratio. That's not bad, considering the fund's high sensitivity to the value premium. However, investors looking for a more-moderate value tilt can find cheaper alternatives, such as Vanguard SmallCap Value (0.10% expense ratio).

Other Alternatives
WisdomTree International SmallCap Dividend (DLS) (0.58% expense ratio) and  WisdomTree Emerging Markets SmallCap Dividend (DGS) (0.68% expense ratio) offer the same approach as DES in developed and emerging markets, respectively.

 PowerShares FTSE RAFI US 1500 Small-Mid (PRFZ) (0.39% expense ratio) offers an alternative fundamental weighting approach. It weights its holdings based on historical dividends, sales, book value, and earnings. This gives PRFZ a broader portfolio with a lower dividend yield. It is also less sensitive to the value premium than DES.

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Alex Bryan has a position in the following securities mentioned above: VBR. Find out about Morningstar’s editorial policies.